Monday, January 20, 2014

Larry Summers' Martin Feldstein Speech

The latest NBER Reporter has the speech Larry Summers gave at the annual NBER "summer camp" for economists. As you would expect, there are some really interesting bits, which provoked a good lunchroom discussion. To my mind it (and this blog post) gets much better toward the end.

The organizing thread is Larry's worries about long term trends in employment and income distribution, and how trends in productivity and innovation affect it. If the word did not have negative connotations, I might term the talk "neo-Luddite," the worry that this time, unlike all the others, technical change, primarily information technology, will be really bad for workers.

Ouch. "Unemployment" figures in the popular press, but it is the fraction of people actively looking for jobs. The far bigger worry among many economists is the rise in "non-employment." One in ten men, 25-50, are simply not working at all or even looking for work.

And as you would expect, these patterns are substantially more pronounced if you are less educated. They are substantially more pronounced if you are in a disadvantaged group than if you are in an advantaged group.

Larry treads lightly, I think, around the issue non-employment raises. If our economy has a rising "skill premium," in economist language, or "doesn't provide good steady jobs to high school grads like it used to," in the more colorful Grease-era nostalgia of, say, the New York Times, or even if the haves are exploiting greater "power" against the have-nots, you would expect to see, and worry about, wages of low-skill people. But you would not expect to see an army of 25-54 year old men not working at all. Wages in Bangladesh are very low. And 25-54 year old men work really hard. Wages in the US in 1910 were really low, and 25-54 year old men worked really hard. If they didn't, they and their families didn't eat. Which, to be clear, I am not applauding. We're simply trying to understand a phenomenon. How do poor opportunities (if that's the problem) in the US translate into not working rather than working at low wages? Larry:

This is associated with what is also a defining feature of our time. In the United States today a higher fraction of the workforce receives disability insurance than does production work in manufacturing...

These phenomena are related. No one could give a Feldstein lecture without recognizing the possibility that a social insurance program had a distorting disincentive effect and that is certainly the case with respect to disability insurance. But I think it is also fair to say that the evolution and growth of disability insurance is substantially driven also by the technological and social changes that are leading to a smaller fraction of the workforce working.

Casey Mulligan might point out that Social Security disability is only one of hundreds of distortions and punitive marginal effective tax rates pushing people out of work.

And what does that last sentence mean? "Technological and social changes" are not disabling millions of people -- work is physically safer than ever. Does he mean that SSDI is a desirable ruse for our government to give up and pay people to not work whose productivity has fallen below a certain threshold?

Anyway, for the rest of Larry's talk he focuses on low wages, which is the deeper driving question. In standard economics Y=AF(K,L), either more technology A or more capital K raise the marginal product of labor and hence wages. So why are we now suspecting that technological progress is reducing wages?

Larry put up a suggestive production function Y = F(βK, L + λ(1 ‒ β)K) in which more capital is supposed to lower wages. I spent a few hours trying to work out his "moment's thought," but was unable to verify its conjectured properties. This looks like a good problem set for a micro class or a blogger with more time on his hands.

Next, and getting more interesting, he put up this table of CPI values

Good or Service

September 2012 CPI Value (1982-4 = 100)

College Tuition and Fees

706

Medical Care Services

445

Medical Care

419

Services

272

Energy

258

Food

234

All Items

231

Housing

223

Transportation

224

Apparel

127

Durables

112

Toys

53

Televisions

5

The issue: Are "stagnant wages" really stagnant in real terms? Well, measured in terms of toys or televisions, not at all. In terms of, say, tuition at Harvard and Chicago, yes indeed.

About televisions,

Television sets at five stand out. That is obviously a reflection of a rather energetic hedonic effort by the Bureau of Labor Statistics.

This is an interesting side note on measurement. Do televisions really cost 1/20th of what they cost in 1980? A TV in 1980 cost about $500. A TV now costs about $500. Every computer I have bought since 1982 has cost $2,000. What's going on? Televisions now are much better than televisions back then. The BLS accounts for this fact by comparing televisions when a new model comes in. Suppose an old tube TV is selling for $500. The first LCD television comes in and sells for $5,000, and a few hedge fund managers buy them. The BLS figures that the LCD TV is the same as 10 old fashioned TVs. LCD TV prices drop to $500, and nobody buys tube TVs any more.The BLS figures that LCD TVs are still the same as 10 tube TVs, so the price of all TVs has gone down by a factor of 10, just as if you could buy a tube TV for $50.

The problem is, early adopters are willing to pay a large premium for new goods. I'm not an expert on hedonic adjustment, but one wonders how it corrects for early-adopter price discrimination.

But on to the real point, really the most interesting of the talk. However measured, "things" have gotten really cheap. They've also gotten a lot better. Many things have gotten so cheap that they are small fractions of our budgets, so further productivity improvement does not show up in cost of living measures. Many services have not gotten cheaper. We count on productivity growth to raise living standards, so the big issue is really productivity growth in services:

In those parts of the economy that are well modeled by the introductory economics textbook treatment of widgets - firms producing a thing with workers with increasing marginal costs in a somewhat competitive industry, such as durables, clothes, and cars - we've seen continuing, very substantial growth in real wages as measured by the purchasing power of things that our economy produces. The reason that [measured] real wages in aggregate have stagnated is that much of what people buy are things where there are issues of fundamental scarcity: energy, the land under the houses we buy, and goods and services that are produced in complicated, heavily public-sector-inflected ways. Medical care and educational services are examples of the latter category....

Larry puts up a chart of where the jobs are going to be in the future,

And you get another part of the picture. The big price growth, and the big employment growth, are happening in heavily government run or government influenced sectors. Like health care.

As a society, we are going to need to come to grips over the next couple of decades with..the propensity for the slow-growing [and fast-inflating!] sectors to end up in the public sector...

Whether the expansion of those sectors as a share of the economy necessitates a growing share of the public sector in the economy, or whether the share of healthcare and education that takes place in the public sector should decline will be a matter of great public debate. As a country, and not without controversy, we do not seem to be moving toward a smaller public role in healthcare. Nor do other countries in the world. But that will, perhaps, change over time.s

Indeed. One conclusion [not Larry's!] you can draw is that greater government involvement has caused lack of competition, innovation, productivity growth and price increase in the sectors it has come to dominate, and therefore is a large part of the cause of stagnant real wages measured by CPI. I don't have any idea by what economic or political force Larry imagines larger shares of any industry "necessitate" government involvement.

Blog readers will know where I stand. Sectors like health care can have huge productivity improvements if governments get out of them. Services like airlines, package delivery, and telecommunications, have all seen huge productivity improvements when governments got out of them. Service sector like retail that our government never was in (other than to slow down low-cost entrants that serve poor people, from A&P to Wal-Mart) have seen huge productivity gains.

Those improvements benefited the denominator of consumer's real wages, and lowered the numerator of income inequality -- pilots don't get paid what they used to. As Larry points out, the burden of taxation goes with the square of the tax rate, so as the economy shifts to services it is simply impossible for the government to keep expanding. But his (to me) depressing forecast of where we are going remains (to me) sadly true.

Larry closes with the deepest thought of all.

..I invite you to consider how the prodigious change associated with information technology that may be qualitatively different from past technological change may have defining implications for our economy going forward. If I have caused you to reflect on the fact that very substantial relative price changes are likely to be associated with dramatic changes in the structure of employment, the nature of economic activity, and the relative importance of the widget-producing firm in our economy, and to consider the implications this will have for the future of the subject with which I began my career in economics under Marty's tutelage, public economics, then I will have served my purpose this afternoon.

This is a thought that's been on the back of my mind for a long time as well. Our Econ 101 widget company and supply and demand graph are really strained as a description of most modern transactions. Pretty much anything you buy represents not the transfer of a good, but the application of someone's expertise and information. Even getting your car fixed, you are not buying someone's labor as if you or I could do it but just have better things to do. You're buying expertise, information, the fruits of human and organizational capital. There is a Big Paper to be written thinking through how an economy where "things" have become free but services, information, and expertise constitute economic transactions.

The first question is, what distinguishes these new "service" transactions from "widgets?" Larry's list is, from above, "issues of fundamental scarcity: energy, the land under the houses we buy, and goods and services that are produced in complicated, heavily public-sector-inflected ways," and later "sectors where property rights, scarcities, intellectual property, and the like are of fundamental importance."

One line of reasoning looks for a definition by going straight to public choice, and focuses on public-sector-influenced. This does not strike me however to be particularly correlated with widget vs. non-widget. Yes, our government has become, in the apocryphal quote, an insurance company with an army. But other governments have run steel companies, locomotive factories, and oil drilling and refining operations with much the same productivity results as we are seeing in government-provided services.

I find it more interesting to think about the private sector part. What distinguishes medical care (ok, vet, lasik, and plastic surgery; let's think about market economics) and software development from widgets?

I don't think "fundamental scarcity" is it. Energy is turning out not to be fundamentally scarce after all. The long-run supply curve is very elastic. Land in mid-town Manhattan, or in the parts of the San Francisco peninsula permitted for construction by zoning laws is indeed scarce. Land on the outskirts of Las Vegas is cheap.

That leaves "property rights, scarcities" -- scarcity of people with desired skills -- and "intellectual property." To which I might add information and expertise.

So how do we think of a world where things are free and economic transactions consist of performing services for each other -- services that require time (substituted for by software) expertise, and substantial human capital? That does strike me as the important Big Question. Maybe Larry's production function is a place to start.

This gets us far away from Larry's neo-Luddite worries. Which I don't mean to denigrate. But we sort of know the answer. The returns to skill will be large. The fascinating question is why, after 30 years of a rising skill premium, the production of skill seems not to have flooded the market, driving down that premium? Are the government involvement in education, and the disincentives to work Larry mentions perhaps even more powerful disincentives to human capital accumulation than they are to getting up to go to a miserable minimum-wage job?

24 comments:

John, from an old undergrad floormate of yours, you make some interesting points. It occurs to me that roughly 100 years ago, as you pointed out, everyone sought to work, even if at low wage levels, because they really had no choice. The incentive to work at low wage levels is disappearing. In turn, this seems to mean that the incentive for the poorly/undereducated to work is also far lower than it was. Quite a quandary we have built for ourselves.

"Larry put up a suggestive production function Y = F(βK, L + λ(1 ‒ β)K) in which more capital is supposed to lower wages. I spent a few hours trying to work out his moment's thought, but was unable to verify its conjectured properties."

Careful here. Treating K (capital) and L (labor) as recurring cost inputs, you can arrive at a production function where costs are divided between capital and labor - increased capital costs result in lower labor costs and vice versa - all else being equal (raw material costs, regulatory costs, etc.).

"The demand curve usually slopes downwards from left to right; that is, it has a negative association (for two theoretical exceptions, see Veblen good and Giffen good). The negative slope is often referred to as the law of demand, which means people will buy more of a service, product, or resource as its price falls."

"The demand curve is related to the marginal utility curve, since the price one is willing to pay depends on the utility. However, the demand directly depends on the income of an individual while the utility does not."

"Non-price determinants of demand are those things that will cause demand to change even if prices remain the same—in other words, the things whose changes might cause a consumer to buy more or less of a good even if the good's own price remained unchanged. Some of the more important factors are the prices of related goods (both substitutes and complements), income, population, and expectations."

When a company invests solely to improve efficiency (more nominal $ worth of goods produced per nominal $ of input) we cannot say what effect this will have on the demand curve because we cannot say what happens to the non-price determinants of demand (population, income, etc.).

Clarification on economic "efficiency":

Case #1: Suppose there are no capital markets (equity and debt). The only costs that a company incurs are real time (labor and material). The company operates as a pass through enterprise - no profit / loss statement - labor and material costs are not downwardly rigid. Now suppose that company wants to improve efficiency - more nominal $ worth of goods produced per nominal $ of cost. In that case it would no longer be a pass through enterprise - it would be trying to run a surplus which means some other economic participant would need to run a deficit.

Case #2: Suppose again there are no capital markets (equity and debt). The only costs that a company incurs are real time (labor and material). The company operates as a pass through enterprise - no profit / loss statement - labor and material costs are not downwardly rigid. However, now we redefine the efficiency of a company to mean the quantity of goods produced per unit of time (widgets per hour for instance). A company can now improve its efficiency by hiring more workers or making technological / labor productivity improvements.

Case #3: There are capital markets (equity and debt). The costs of a company include are labor, material, and financing costs. The company operates as a for profit enterprise - profits are passed onto equity holders. Labor and material costs are not downwardly rigid - debt holders get liquidation value of the company.

How do you define a company improving its efficiency? Using the case 1 example, a company's efficiency is improved whenever the ratio of its nominal $ output to nominal $ expense rises (its profit margins rise). Using the case 2 example, a company's efficiency is improved whenever the quantity of goods produced per unit of time increases (irrespective of profits).

Which definition of "efficiency" do you prefer and I can probably give you a better answer to your question?

We can only buy services. Ownership is simply a nexus of contracts. When one buys an oject, one is really only securing some bundle of services from the seller, the government, and, maybe, some other folks.

What passes for education is a screening function, nothing more. Survive college and you can't be all bad. Pretty expensive, though. Those that don't work have been screened out but find a tolerable existence given transfers and the minimum wage. [A possible answer to the last pair of questions.]

So you think that neurosurgeons or nuclear physicists are just being filtered out of the general population? Take 2 individuals with the same aptitude, and one trains to be a neurosurgeon and one takes a job at walmart, is there no difference in their skill after 10 years? Clearly education is definitely not filtering in any important or fundamental way. Yes colleges need to filter for aptitude at a point in time, but even that is dependent on prior accumulation of human capital.

I think Prof. Summers' claims about allowing capital to substitute for labor don't go as far as one might like. I parse his text as sketching a derivation like this: 1. The first order condition for beta fixes F_k = λ F_l, and the marginal productivity of capital for both purposes is equated. 2. Now compare an economy where λ=0 to an economy where λ>0. Holding capital and labor fixed, we can sign the effect on wages, because it is the opposite sign of the derivative of F_l with respect to beta. This equals k F_{k,l} - λ k F_{l,l}, so it is always positive. The two terms represent the "stock of conventional capital falling" and the "rise in effective labor." 3. Because β=0 is always a possibility total output weakly increases. 4. When output increases and wages decrease the labor share falls.

I imagine trying to do the comparative dynamics would be more painful, involving solving for the new steady state and so on. My intuition is that repeating the same comparative statics approach with a flexible labor supply would result in decreased employment.

‘The first question is, what distinguishes these new "service" transactions from "widgets?"‘

‘One line of reasoning looks for a definition by going straight to public choice, and focuses on public-sector-influenced. This does not strike me however to be particularly correlated with widget vs. non-widget.’ - Dr. C.

Widget transactions and service transactions, may in fact be the same, in terms of, one person exchanging their labor for another person’s labor to acquire [transact] widget or service. “Labour therefore, is the real measure of the exchangeable value of all commodities.” - Adam Smith

Returning to Buchanan and Tullock [public choice theory] and some public choice from Milton Friedman as well (other people‘s money): is the process of “transaction” be it widget or service influenced more by an era , or more succinctly influenced by a return to an era, predating Adam Smith i.e. transactions more akin to government privilege economies which existed, as the predominant economic organization, before the year 1700?

Further, in Thomas Sowell’s magnum opus, Knowledge and Decisions, a discussion/observation is put forth that the world of possible transactions have been reduced by government intervention. Reductions in the universe of transactions being a drag on an economy.

Hence “transaction” is influenced as well as reduced by politicos through the mechanism of government with the result being akin to, if not an exact replica of, government privilege economies.

Is Summers discussion really a discussion of government failure albeit avoided at all costs by Summers?

“Government is the only enterprise on earth, that when it fails, it merely does the same thing over again, just bigger.” - Don Luskin

"Energy is turning out not to be fundamentally scarce after all. The long-run supply curve is very elastic." I do not believe that to be correct. It remains to be seen what the long run supply curve of energy is. The only "limitless" source of energy we know of is nuclear and that seems problematic in light of the safety concerns.

Nor do I believe that there are rising skills premiums. The most skilled workers now may be more skilled than the most skilled workers 30 years ago and be paid more but that does not mean that the premium is rising. There has been a general rise in incomes. Skilled workers have seen their incomes rise in relative terms compared to less skilled workers because they have not come into direct competition with the Chinese hordes. The real wonder is why the excess returns and incomes in the financial sector have not been bid away.

About the higher number of 25-54 old men not working, how does it compare to the number of 25-54 old women not working? How much is explained by men taking on the stay at home parent role while the other spouse is earning income?

A wife able and willing to work outside the home would have as big a wealth effect on her husband's labour effort as any welfare program he could qualify for, if not more so. If a married man loses his job, he can take more time finding the "right" job, and is less likely to pack up and move to where the work is if his wife is working than would a single man or a married man whose wife isn't employed outside the home. Presumably that's a good thing.

Oh, by the way---if she's like most women, the wife probably works in one of those services that are eating us out of house and home, or something.

I am not sure we are talking about the same thing Richard. Men not working are NOT looking for a job. I was wondering which proportion are not working because their spouse is the bread earner and they are in charge of childcare and other household work. These would still be one parent at home and one parent working types of households.

I apologize but I simply do not understand what you mean by “that are eating us out of house and home, or something”.

It strikes me to read this nonsense from someone so highly regarded as Summers. Energy scarcity? Land scarcity? What is he talking about?. There is no energy scarcity and oil wont run out by the year 2000.Technological improvements will always have tremendous beneficial impacts on our standards of living. How does he measure, for example, the biotechnology that has dramatically increased agriculture production in the last 30 years?I think sometimes some economists like to complicate things more than what they truly are. Lower the deficit, reform the tax code, get rid of unnecessary regulations and economic growth will come back, its not so complicated.

When I was working as a technological forecaster, I had to do the equivalent of finding hedonic indexes for multi-component technologies (although I did not use the BLS methods; I invented several new ones). The problem is not simple, because it deals with a multi-dimensional space of product characteristics. Take the TV example. A flat-screen digital TV not only has better resolution than any tube TV ever did, it accepts inputs such as HDMI from computers or from cameras, something that no tube TV ever did. How can these additional product characteristics be incorporated in a hedonic index? I'm not sure they can. I think the simplest way to approach it is to take a TV as an entity. We've re-defined the characteristics of that entity by adding some, but it's still all one thing. Probably the best way to value the thing is to ask how long must a consumer work to purchase it. In the long run, time is the only irreplaceable thing we have. And clearly almost any "thing" we want to buy takes less and less of our time to earn. The problem seems to be that in the case of "services," we're buying other people's time. Some services are simple. Five minutes of a checkout clerk's time isn't very expensive, because lots of people can handle that job. Five minutes of a hospital nurse's time as she checks my blood pressure in the middle of the night (I am still recovering from surgery, so this example is still vivid in my mind) is worth a lot more, at least in part because there are many fewer people who can handle that job. Automating services, or at least aiding them in some way, is at least one approach to reducing the amount of other people's time needed to perform them. For instance, when I'm grocery shopping and have only a few items, I'll go through the self-serve checkout rather than spend more of my time waiting in line. That way I can completely avoid using someone else's time. As I see it, we need to find ways to quit using so much of other people's time to perform services.

"energy, the land under the houses we buy, and goods and services that are produced in complicated, heavily public-sector-inflected ways. Medical care and educational services are examples of the latter category"

Energy: The biggest energy story of the last 20 years has been the shale gas boom in the US. Natural Gas in the US is now ~$4.50/mmbtu. It has displaced coal in electrical generation, shut down nuclear development, and has revitalized several industries in the US such as basic chemicals. By way of comparison, a barrel of oil has about 6 million BTUs, and should trade on an energy equivalent basis at ~$27/bbl. That oil persists at ~$110 in international markets is probably a commentary on the political instability of West and Central Asia. Not that oil in the center of the US trades as much as $15/bbl. less than internationally. Clearly, if we could conduct a decimation of envirommentalists and lawyers, and lease out federally owned land in the US and offshore, we could keep the price of oil way down for a very long time.

Land: Only in the Northeast and the Bay area. In the central US land is cheap. I wonder what a square mile of Detroit would cost?

Medical care: The US spends >16% of gdp on medical care. This is 400 bps more than any other industrialized country.Clearly we are doing it wrong. There is nothing inevitable about it. It's just politics of the worst sort. it will be very hard to change. But it is most definitely not anything about medicine itself.

Education. Ditto to medicine, in spades and with unions.

Medical care, education, and general government (e.g. cops, firemen, and armies) run more than 25% of GDP. Reining them is necessary, but will be extraordinarily difficult.

It's not clear we pay too much for medical care considering that we pay for the development of all the new medications and technologies while the rest of the world free rides on our investment by charging marginal production costs.

It is waaayyy un-PC to mention it, but there are 3.7 million veterans receiving monthly disability checks from the federal government. Young guys, mostly (less than 54, that is). There are about 8 million SSDI'ers receiving disability.

If you think the vets on disability are war-injured, you are naive. That number is well under 100,000.

I can assure you that the vet disability program will never be challenged, or even mentioned, in left- or right-wing circles. I notice the cited paper above mentions nary a word about vets and the huge vet disability program.

BTW, if you peruse the VA website, you will see they can show you number of vets by congressional district, and so on. The website contends that one in four Americans qualifies for some sort of VA benefits.

Nancy Pelosi told Bob Gates (in his book "Duty") that the veterans organizations determined vet policies, that is the way Congress worked.

How come no one, at least no one who I have read, postulates that these men in that 25-54 year old age group (the one where men have skills and work hard) are not working in the underground economy. I can assure everyone that there are huge sums of these people (and women too) who are working for currency and not reporting to the IRS what they earn. And be assured as well, that a huge percentage of people who do work and report their income underreport their incomes by huge (and I'm not talking 15% here) amounts.

Everyone seems to ignore globalization. Global development means we can import "stuff" cheaply, in exchange for high-skill services. That should drive up demand for servants, gardeners, restaurants workers, and so forth. But we have a huge number of immigrants competing with low-skill native labor, so wages are low and people prefer to live on disability payments or crime, retire early, work for the government, pretend to be studying in college, etc.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.

About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!